SCHWAB-POMERANTZ: What’s the Best Way to Set up an Education Fund for My Grandchild?

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Dear Carrie: I’d like to set up an educational fund for my new grandchild. I understand the tax benefits of a 529 account but am also interested in gifting appreciated stock. What are your thoughts? — A Reader 

Dear Reader: Congratulations on your new grandchild! I also applaud your generosity. What a fortunate child to have such a supportive family. 

You’re also wise to weigh your options. A gift of appreciated stock can be a great way to fund education. On the other hand, as you mention, a 529 account has several advantages, but it only accepts cash, not stock or other assets. 

As is so often the case, the devil is in the details. Regardless of whether it’s you or your grandchild who ultimately sells the appreciated stock, that person may be hit with a tax bill that can include federal capital gains tax and, potentially, net investment income tax and state taxes. 

New rules under the Tax Cuts and Jobs Act of 2017 mean that gifting appreciated stock to a minor is far less attractive than in the past. In a nutshell, assets owned or sold under a child or grandchild’s name can be hit with tax rates faster and higher than assets sold by a parent or grandparent. 

As a Grandparent, You Have a Few Ways to Gift the Stock

1. You can gift the stock in kind and have it sold under the grandchild’s name. This used to be a common strategy under old tax rules. As we’ll discuss below, it’s not as effective as it used to be.
2. You can sell the stock and gift the after-tax proceeds to your grandchild. This can make sense if you would pay lower taxes on the sale than your grandchild would. New tax rules can result in a child or grandchild’s tax liability being higher than that of a grandparent.
3. You can make a gift of the stock to your grandchild at your death. This takes advantage of a step up in basis, which means paying no taxes on any appreciation on the stock. In this way, you can make a larger gift, but the downside is you won’t be around to see it.

A big part of your decision, therefore, will be based on the difference in the total tax burden for you versus your grandchild in selling the stock. In addition, you’ll want to weigh the pros and cons of placing college funds in a custodial account versus a 529. Let’s take a closer look. 

A Few Tax Basics for the Grandparent

When people sell stock in a taxable account, they may have to pay capital gains taxes on any appreciation from the sale. Whoever owns the stock is also subject to income taxes from dividends paid out when holding the investment. 

The capital gains tax rate is based on how long the stock has been held. Appreciation on stock held for one year or less is taxed at ordinary income tax rates where the highest federal tax rate is 37% (2019). 

Long-term capital gains (LTCG), on the other hand, are taxed on the appreciation of stocks that had been held for more than one year and sold. Federal LTCG rates vary from zero to 20% based on income.  

(When you gift property, your grandchild assumes your holding period. So, your grandchild doesn’t need to wait another 12 months to sell the stock to be eligible for LTCG rates.) 

Note that single individuals with a modified adjusted gross income (MAGI) more than $200,000 and married filers with a MAGI over $250,000 will also owe an additional net investment income tax (NIIT) — sometimes called the Medicare surtax — of 3.8% on top of LTCGs.

What You Need to Know About the New “Kiddie Tax” Laws 

Kiddie taxes are special tax rules on investment and other earned income of minors. A main goal of gifting appreciated stock to someone like a grandchild or child is to shift the taxable appreciation of that asset from a presumably higher tax rate (yours) to a lower tax rate (your grandchild’s). In the past, this strategy worked great. You could pay less in taxes to Uncle Sam, and your child would get a bigger gift — a win-win. 

All of that changed, however, with the passage of the Tax Cuts and Jobs Act in 2017. Under this legislation, a minor child’s investment income over a certain limit ($2,200 for 2019) is taxed at the trust tax rates rather than the child’s or parent’s tax rate. LTCG rates increase to the highest rate (20%) for a child/grandchild after just $12,950. The 3.8% NIIT is added on top of this for a total of 23.8%.

Just for the sake of comparison, in order for you to hit this 23.8% LTCG tax rate, you would need to make over $434,550 as a single filer or over $488,850 as a married couple filing jointly. So it’s quite possible that the 23.8% rate could apply to your grandchild selling the stock while a lower 15% LTCG rate could apply to you. Or your LTCG rate could be 20%, and your grandchild’s LTCG rate could be 15%. 

In Any Case, the Main Takeaway Is That the New Kiddie Tax Threshold Makes Gifting Appreciated Stock to Your Grandchild Less Attractive Than in the Past 

Understandably, the new rules have caused some consternation for a number of families, and there have been several legislative proposals to roll back or modify the kiddie tax rules. We’ll have to wait and see what ultimately happens, but for now the 2017 legislation holds.

Don’t forget about state taxes and other potential liabilities. The strategy of gifting rapidly appreciating property removes the future appreciation of this property from your estate and allows you to make the gift when tax values are relatively low.

While the current (2019) federal top marginal tax rate on LTCGs is 23.8%, taxpayers also have to pay state and local income taxes on their capital gains income. The state tax rate can vary from zero percent in states such as Florida and Nevada that don’t levy an individual income tax to as high as 13.3% in California. So where you and your grandchild live may be another variable to consider.

Also, ask your tax and financial advisor about other taxes that could come into the picture including gift taxes, the alternative minimum tax (AMT) or increased taxation on Social Security benefits. Another consideration is that your gift could impact your Medicare premiums, since they are based on your income from the prior year.

With a Custodial Account, Your Gift Might Not Be Used for Education

If you decide to gift your grandchild the stock (as opposed to cash), you’ll likely place it in a custodial account. Using a Uniform Gift to Minors Account (UGMA) or Uniform Trust to Minors Account (UTMA) gives you control over the assets but only until the age of majority (usually 18 to 21, depending on the state). 

At that point, though, you have to understand that your grandchild has full rights to spend the money any way he or she wishes. In other words, your grandchild might decide to use the money for a car, not college, and you have to be comfortable with that possibility. 

Is a 529 Plan a Good Option?

Now let’s look at a 529 plan. I’ve written about 529 plans extensively in the past, and I believe they provide a great tax-advantaged way to fund an education. In fact, they are the most popular education savings plan for savvy families for good reason. But as I mentioned above, 529 plans can only accept cash. 

Still, the proceeds of the stock sale could ultimately be used to fund a 529. A grandparent- or parent-owned 529 has lots of pros including the following:

— Provides for more control over the gift to ensure that it’s is used for education.

— Can be more advantageous if applying for need-based financial aid in the future.

— May be eligible for a state tax deduction.

— Offers tax-free growth on qualified distributions.

That said, remember that 529 accounts are specifically designed for education costs. If you want your grandchild to be able to use the funds for something else, a 529 account may not be the best choice. Withdrawals from a 529 that are considered nonqualified are subject to ordinary income taxes and a 10% penalty.

Your Gift Can Combine the Best of Both Approaches 

Rather than an either/or decision, you could open both a 529 plan and a custodial account, possibly funding different accounts in different years. In the future, a UGMA/UTMA could be used to cover expenses for your grandchild not covered by the 529 (like clothes, a car, summer camp or flights home from school).

Gifting As Part of an Inheritance Could Allow for a Bigger Gift 

Taking a completely different tact, you should understand that a gift of the appreciated stock at your death results in a step up in the cost basis, potentially greatly reducing the tax liability. This can be an option, especially for older grandparents closer to the end of their retirement who might be able to make a larger gift of the appreciated stock as part of their estate. 

Next Steps

As you can see, finding the best way to fund a grandchild’s education can be complicated business. There are lots of moving parts, so it’s important to consider all your options before making a decision. Most of us will do well to work out the specifics with a tax advisor and financial planner. These experts can help you refine strategies such as the timing of the gift and tactically combining a 529 plan with a custodial account. Who knows — you may be able to give more to your grandchild than you think!

Carrie Schwab-Pomerantz, Certified Financial Planner, is president of the Charles Schwab Foundation and author of “The Charles Schwab Guide to Finances After Fifty.” Read more at http://schwab.com/book. You can email Carrie at [email protected]. The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. To find out more about Carrie Schwab-Pomerantz and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate website at www.creators.com.

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